Breaking Up Big Banks Is a Severely Conservative Project

Oct. 29 (Bloomberg) -- The columnist George F. Will
recently shocked his fellow conservatives by endorsing Richard
Fisher, president of the Federal Reserve Bank of Dallas, to be
Treasury secretary in a Mitt Romney administration.

Fisher’s appeal, in Will’s eyes, is that he wants to break
up the largest U.S. banks, arguing that this is essential to re-establish a free market for financial services. Big banks get
big implicit government subsidies and this should stop.

Will’s endorsement was on target: The true conservative
agenda should be to take government out of banking by making all
financial institutions small enough and simple enough to fail.
As Will asks, “Should the government be complicit in protecting
-- and by doing so, enlarging -- huge economic interests?”

But Will could have gone further -- much of what Fisher
recommends also is appealing to people on the left of the
political spectrum. Fisher should be considered for a top
administration post regardless of who wins the presidency on
Nov. 6. He also should be a strong candidate to become chairman
of the Federal Reserve Board when Ben Bernanke’s second term
ends Jan. 31, 2014.

Unfortunately, Fisher’s views on “too big to fail” banks
draw the ire of powerful people on Wall Street, and he almost
certainly will remain in Dallas. That is, until the next crisis.

Policy Rethink

Fisher and Harvey Rosenblum, executive vice president and
director of research at the Dallas Fed, have laid the groundwork
for a comprehensive reassessment of finance and banking -- and
the effects on monetary policy. The closest parallel is the
rethink that happened during the 1930s, as the gold standard
broke down and the world descended into depression followed by
chaos. But their approach is also reminiscent of the way that
monetary policy was reoriented in the early 1980s, as Fed
Chairman Paul Volcker and others brought down inflation.

The world and the U.S. economy have changed profoundly. We
need to alter the way we think about the financial system and
monetary policy.

Fisher and Rosenblum have expressed, separately and
together, three deep ideas since the financial crisis erupted in
2008.

First, very large banks are too complex to manage. “Not
just for top bank executives, but too complex as well for
creditors and shareholders to exert market discipline,” they
wrote in a Wall Street Journal op-ed in April. “And too big and
complex for bank supervisors to exert regulatory discipline when
internal management discipline and market discipline are
lacking.”

Complexity, they say, magnifies “the opportunities for
opacity, obfuscation and mismanaged risk.” This is a problem in
other industries, too, though market forces compel U.S.
businesses to reconfigure their organizational structures all
the time, including through divestitures and by becoming smaller
in other ways.

Banking is different. There are large implicit government
subsidies available if your financial institution is perceived
as too big to fail. These subsidies -- in the form of implicit
downside protection or guarantees for creditors -- drive up size
and exacerbate complexity.

Second, too-big-to-fail banks do actually fail, in the
sense that they require bailouts and other forms of government
support. This is exactly what happened in the U.S. in 2007
through 2009, and it is what is occurring in Europe today.

Breaking Up

For anyone who finds the phrase “break up” hard to swallow
-- for example because you believe the government shouldn’t take
on this role -- Fisher and Rosenblum argue: “Though it sounds
radical, restructuring is a far less drastic solution than
quasi-nationalization, as happened in 2008-09.”

Third, monetary policy cannot function properly when a
country’s biggest banks are allowed to become too complex to
manage and prone to failure.

In “The Blob That Ate Monetary Policy,” a Wall Street
Journal op-ed published in September 2009, Fisher and Rosenblum
pointed out that cutting interest rates doesn’t work when
systemically important banks are close to insolvency. The
funding costs for banks go up, not down, as a crisis develops.
So pulling the classic policy lever, the federal funds rate,
becomes less than effective in such an environment. (For more,
see this essay and this article.)

As banks come under pressure, the Fed may cut its policy
rate but the interest rates charged by banks to customers may
actually go up, and it becomes harder to get a loan. This is
what happened in 2008 and 2009.

Or think about what happens during any attempted economic
recovery -- such as the one we are in now.

“Well-capitalized banks can expand credit to the private
sector in concert with monetary policy easing,” Rosenblum wrote
with his colleagues Jessica J. Renier and Richard Alm in the
Dallas Fed’s “Economic Letter” of April 2010. “Undercapitalized
banks are in no position to lend money to the private sector,
sapping the effectiveness of monetary policy.”

If you want monetary policy to become effective again, you
need the largest banks to be broken up. Equity capital also must
increase, relative to debt, throughout the financial system.

(Simon Johnson, a professor at the MIT Sloan School of
Management as well as a senior fellow at the Peterson Institute
for International Economics, is co-author of “White House
Burning: The Founding Fathers, Our National Debt, and Why It
Matters to You.” The opinions expressed are his own.)

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on the policy implications of this presidential election; A.
Gary Shilling series on the perils of low interest rates; Shikha
Dalmia on how Republicans must root out hatred of immigrants.